Derivatives are viewed as one of the most complex investment instruments. The derivatives market was first introduced in India in the year 2000. The Indian derivatives market has grown significantly in importance among Indian traders since its inception. Derivatives are exchanged on stock markets much like shares. The daily turnover in the exchange’s derivatives section serves as a parameter for the popularity of the derivatives market. Let’s discuss what derivatives are before learning about the risks of trading them.
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Derivatives Explained
Derivatives are financial contracts whose value is derived from an underlying asset. These include interest rates, equities, indexes, commodities, currencies, and exchange rates. By speculating on the potential appreciation of the underlying asset, you can make profits in the derivatives market. Therefore, the value of the underlying asset determines its worth. They are named “Derivatives” for this reason.
The underlying assets’ value fluctuates continuously. An investor can make a profit with these price changes. They could also result in losses. This is when using derivatives is useful. If you predict the future price accurately, it might help you make more money. It could also serve as a safety net against losses in the spot market, where the underlying assets are exchanged.
Risks Involved in Derivatives Trading
Hedging risk is a well-known use of derivatives. This is among the top factors contributing to its increasing popularity among traders. However, there can be a certain amount of risk. You should be aware of the following risks associated with trading derivatives.
Market Risk
The overall risk associated with any investment is the market risk. Rather than one or many securities, there is the possibility that the market as a whole might lose value. Economic recessions, general economic circumstances, changes in interest rates, political turmoil, etc., are some of the factors that contribute to market risk. Analysing an investment option and carrying out extensive research are crucial steps to take before trading derivatives.
Counterparty Risk
One of the parties to the derivative contract (counterparty) may file for bankruptcy. It goes by many names, including credit risk, legal risk, settlement risk, etc. When two people sign a contract, there’s a chance that one of them will not abide by the contract.
Duration Cap
In derivatives trading, there is a contract expiration date. The contract expires as soon as the due date approaches. Losses might occur if the investment doesn’t perform well within that time frame.
Unpredictability
There’s a chance that the contract’s underlying security will always lose value. Price swings can cause volatility to the extent that one party incurs heavy losses in a day. You must become skilled at efficiently managing these risks before you engage with derivatives trading. The market is never secure in the realm of derivatives. To trade in such an avenue, you need to be a cautious trader.
Tips to Trade Derivatives
Let’s now take a glance at some useful tips to trade derivatives safely.
- Ensure that you have the minimum amount for trading in your margin account. You must always keep your margin amount according to market regulations. Therefore, until your trade is settled, you will be unable to withdraw this money from your trading account. The margin amount fluctuates in tandem with changes in the underlying stock’s price. This is why you should constantly make sure that you have additional money in your account.
- Make sure you carry out extensive research. Keep in mind that different strategies are required for the derivatives market than for the stock market. For instance, you can make a trade to buy equities that you think will see a spike in demand. However, this will need a sell order in the derivatives. Thus, the approach would differ.
- Based on the amount you have, the underlying price, the required margin, and the contract price, select your stocks and their corresponding contracts. A certain amount of funds will be needed to sign your contract. Do not settle the trade until the contract expires. In this instance, you are expected to settle the unpaid balance in full. Or else, you take a position in the opposing trade.
Conclusion
Derivatives are no different from other assets in the financial market. They also have their share of advantages and disadvantages. Trading in derivatives requires a lot of knowledge and experience. Therefore, investors need to conduct thorough research and formulate effective strategies to minimise losses. Moreover, you should trade on good platforms that provide you access to helpful trading tools. They help in understanding the market and trade accordingly. So, always prefer the best trading app in India to trade derivatives. Some reputed financial houses like Kotak Securities offer excellent platforms to trade derivatives effortlessly. You get an array of features that assist in analysing the derivatives market accurately.